The Financial Crisis Conventional Financial Theories

Following the 2008 Financial Crisis, conventional financial theories have been challenged for their inability to realistically explain risk. Traditional strategies of asset pricing often rely on a normal bell curve to make market assumptions, but in reality, the markets do not behave this way. Under a normal distribution, a majority of asset variation falls within 3 standard deviations of its mean which subsequently understates risk and volatility. Unfortunately, history would suggest financial markets do not always act in this manner and rather, they exhibit fatter tails than traditionally predicted. By definition, fat tails are a statistical phenomenon exhibiting large leptokurtosis. This represents a greater likelihood of extreme events occurring similar to the financial crisis. Since the magnitude of fat tails are so difficult to predict, left tail events can have devastating and unexpected effects on portfolio returns. As a result, sufficiently protecting a portfolio requires t ail risk hedging from unexpected market events. Normal Distribution In order to understand the significance of tail risks, it is imperative to understand the notion of a normal distribution and its shortcomings. A normal distribution assumes that given enough observations, all values in the sample will be distributed equally above and below the mean. About 99.7% of all variation falls within three standard deviations of the mean and therefore there is only a .3% chance of an extreme eventShow MoreRelatedConventional Financial Theories Of A Normal Distribution919 Words   |  4 Pages2008 Financial Crisis, investors have challenged conventional financial theories for its inability to realistically explain risk. Traditional strategies and asset pricing often rely on a normal bell curves to make market assumptions, but in reality, the markets do not behave this way. Under a normal distribution, a majority of asset variation falls within 3 standard deviations away from its mean which often understates risk and volatility. Unfortunate ly, the historical landscape of financial marketsRead MoreU.s. Government s Trade Defense Measure1194 Words   |  5 Pagesfrom year 2009 to 2010, even it rises up in next 3 years, and it demonstrates the U.S. government different trade policy stances to respond the financial crisis in different stages. The reason to explain why the U.S. changed its stance to less protectionism after 2010 is trade defense measure could help the U.S. enterprises to survive during financial crisis, to avoid massive unemployment in labor market. The cost of implementing such policy is to sacrifice the benefits of household sectors. Over aRead MoreClassical Financial Theory : Cognitive Psychology And Economics952 Words   |  4 Pagesproblems. 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